The virtue of a defined contribution plan is that once the employer has made their contribution, the employer’s obligation is fulfilled. The employee’s retirement benefit is based on a “defined” contribution – typically some fixed percentage of their base pay – that money is invested, and the retiree lives on the accumulated savings and interest. Often, with the same amount invested, these plans can offer participants a more lucrative retirement than a pension.
Given the potential of defined contribution plans to sometimes outperform pensions, why are public employee unions seemingly focused almost exclusively on the alternative, the so-called “defined benefit” pension? Far more common in the public sector, these defined benefit plans offer the retiree a guaranteed “defined” amount in the form of fixed payments for as long as they live, usually adjusted upwards each year for inflation. What the employer has to contribute to the fund is undefined and fluctuates as needed to maintain those promised payments.
The problem, however, with defined benefits is they were sold as costing taxpayers very little, when in fact the employer contributions over the past twenty years have soared. To say those undefined employer payments to the pension funds have “fluctuated,” in order to keep those defined benefits flowing, is to indulge in the understatement of the century.
Back in 1999, during the internet bubble, when California’s public employers consented to an increase to the value of their promised defined benefits of well over 50 percent, the pension funds claimed it wouldn’t cost anything. The stock market was roaring, and apparently would roar forever.
Today, despite years of relentless increases to the required pension contributions by employers, most of California’s major public employee pension funds are only about 70 percent funded, with steep annual hikes in required contributions scheduled for the next several years. There is no end in sight.
So while a defined benefit may protect a retiree from mortality risk, where they outlive their savings, or market risk, where they happen to retire during a prolonged bear market and their savings evaporate, under the defined benefit plan all that risk is shifted to the taxpayer.
The cold fact that confronts California’s public employee pension systems is this: Their plans, which today are only around 70 percent funded despite the longest bull market in U.S. history, will not be able to financially withstand several years of poor returns on investment. The longer it is before defined benefits are right-sized to the capacity of state and local government to make contributions, the larger those benefit cuts will be.
Meanwhile, many government employers offer defined contribution plans to supplement defined benefit pensions. Given the precarious financial state of pensions, these defined contribution plans should not be attended to as an afterthought.
Some Defined Contribution Plans Are Better Than Others
Wading successfully through the arcana of retirement finance is a tedious exercise, but too much is at stake to avoid making the attempt. And it seems that California’s government unions, which have been universally consistent in making employee pensions run on autopilot, have not been nearly so proactive to ensure their members find the right defined contribution plan.
Since 1958, government employees have had the opportunity to make tax deferred contributions to retirement savings accounts as authorized by IRS Section 403(b). But these early 403(b) plans were marketed to public employees by insurance companies that had already been selling similar plans as tax sheltered annuities.
So far so good. But these plans, which are still aggressively marketed by insurance agents to public employees, carry much higher costs. Most of them have an entry fee – paid back to the salesperson as a commission – as high as 11 percent. Many of them have earnings that capped at rates as low as 3 percent. It isn’t uncommon for them to have a surrender charge as high as 15 percent. All of them charge annual maintenance fees – usually hidden from the plan participant – typically far in excess of more competitive mutual fund based plans that have emerged more recently.
An example of a good plan is the 403(b) option known as Pension2, offered by the California State Teacher’s Retirement System (CalSTRS). Pension2 offers a variety of low-cost index fund options and only charges annual administrative fees equal to 0.25% of the participant’s account balance. But Pension2 does not have an aggressive sales force pushing its product – which of course is one of the primary reasons the product is such a good deal. Other low cost 403(b) options are offered by Fidelity and Vanguard.
Why aren’t the unions encouraging their members to invest in these products? Maybe because the California Teacher’s Association offers its own 403(b) plan, which has an annual administration fee of $95 per participant – regardless of fund balance. By selling its own retirement product, the union loses its ability to act as a credible advisor to its members.
Another excellent option for public employees who want supplemental defined contribution benefits is an IRS 457(b) plan created by their employer in conjunction with a financial firm. Los Angeles Unified School District’s 457(b) plan administered by Voya won an award from the National Association of Government Defined Contribution Administrators (NAGDCA) for excellence and innovation. This excellent 457(b) plan is a good alternative to the 27 403(b) plans being sold to LAUSD educators, mostly by insurance companies.
Why isn’t the United Teachers of Los Angeles (UTLA) recommending this plan to its members? Recent history would suggest that UTLA thinks its members are undercompensated, and one easy way to improve teacher compensation is to reduce the overheads they pay on retirement savings.
While other unions have agreed to LAUSD automatically enrolling employees in their award-winning 457(b) plan UTLA has steadfastly refused. So instead of protecting member savings, salespeople pushing obsolete, needlessly expensive versions of a defined contribution plan continue to ply the halls of California’s schools.
Edward Ring is a co-founder of the California Policy Center and served as its first president.
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